A chapter 7 trustee sued a manager of three limited liability company (LLC) debtors for breach of fiduciary duty and to hold the manager personally liable for distributions made to members, including himself.

The chapter 7 trustee served as trustee for three jointly administered debtors (JK Harris, SBS and Holding). John Harris (Harris) owned at least 60% of the voting interests of Holding, and Harris and/or Holding owned 100% of the voting interests in JK Harris and SBS. Harris was a manager of the manager-managed LLCs and a member of the member-managed LLC.

The debtors filed chapter 11 bankruptcies, which were converted to chapter 7 cases within a few months. At the time of conversion the debtors owed ~$30 million and claimed assets of ~$5.2 million in their bankruptcy schedules, although the assets were mostly accounts receivables that became worthless when the cases were converted.

The debtors were insolvent for at least seven or eight years prior to the bankruptcy filings. During this period the debtors incurred millions of dollars of additional liability and distributed ~$3.5 million to Harris in member distributions (in addition to paying salary and making loans to Harris).

The trustee sued Harris asserting claims under the state LLC act for breaches of fiduciary duty and authorization of unlawful distributions. Harris’ primary defense was that he was unaware of the statutory provisions relied on by the trustee, and he did not know that the distributions were prohibited. Although the trustee did not accept his purported ignorance, the trustee contended that this was immaterial (i.e. “ignorance of the law is no excuse”).

To hold Harris personally liable for a member distribution, the trustee had to prove each of the following elements:

Harris was a manager of a manager-managed LLC or a member of a member-managed LLC.

Harris agreed to or authorized the distribution, which was in violation of the state LLC act or the LLC’s operating agreement or articles of organization.

Harris violated his fiduciary duties under the LLC act.

With respect to the first element, Harris was a manager of Holding and JK Harris, which were manager-managed LLCs, and he was a member of SBS, which was a member-managed LLC.

With respect to the second element: As is typically the case, the LLC act prohibited a distribution to members if afterwards the LLC would not be able to pay its debts as they become due in the ordinary course of business, or if its total assets would be less than total liabilities plus any liquidation preference amounts if the LLC were to be terminated. In this case, even before the distributions the LLCs were insolvent in that their liabilities exceeded the value of their assets. So the member distributions were in violation of the LLC act. And Harris authorized all of the distributions. So, the second element was proved.

With respect to the third element, the court discussed the duties of loyalty and care. The duty of loyalty includes:

“[A] duty to account to and hold for Debtors ‘any property, profit, or benefit derived by the members’ of Debtors.” – Authorizing distributions to himself while the debtors were insolvent harmed the debtors and breached Harris’ duty of loyalty.

“[A] duty to refrain from dealing with Debtors on behalf of someone having an interest that was adverse to the Debtors.” – The distributions “served to plunge Debtors deeper into insolvency” and “use of Debtors’ funds to increase [Harris’] personal wealth was adverse to the interests of Debtors.”

Under the duty of care:

A manager is “limited to refraining from engaging in [1] grossly negligent or [2] reckless conduct, [3] intentional misconduct, or [4] a knowing violation of law.”

Under state law “gross negligence is ‘the failure to exercise slight care’ or ‘the absence of care that is necessary under the circumstances.’”

“‘Recklessness implies the doing of a negligent act knowingly’; it is a ‘conscious failure to exercise due care.’”

Under the statute any of the four types of conduct – grossly negligent, reckless conduct, intentional misconduct and knowing violation of law – constitutes a violation of the duty of care. Consequently, even if Harris did not commit a knowing violation of the LLC act, he could still violate the duty of care based on gross negligence or recklessness.

Although it might seem that it would be difficult to establish a breach of the duty of care since the standard of care is pretty low (e.g. “slight care,” “negligent act knowingly”), the court’s analysis was as follows:

[Harris] was aware that Debtors were insolvent at all times during the Period of Insolvency, but nevertheless authorized and received the Member Distributions, rather than allowing those funds to be used for debt service and ongoing operations. Even as Debtors began accruing millions of dollars in additional liabilities, Defendant continued authorizing and receiving Member Distributions. In doing so, [Harris] deprived the financially insolvent Debtors of funds that could have been used for operations, to attract investors, to persuade additional lenders, or to satisfy some of the very large claims against Debtors. The undisputed facts show that [Harris’] actions in authorizing and receiving the Member Distributions in the face of Debtors’ imminent financial collapse were grossly negligent and reckless.

Thus Harris violated his fiduciary duties and was liable for the member distributions under the LLC act.

Many state statutes (1) provide that a member distribution is not permitted when the LLC is insolvent and (2) hold a member or manager liable based solely on authorizing the distribution, without requiring a breach of fiduciary duty. However, under the court’s approach, the additional requirement that there be a breach of fiduciary duty does not appear to be significant since almost by definition authorizing distributions when the entities were insolvent was viewed as a breach. Members and managers authorize or consent to member distributions while an LLC is insolvent at their peril.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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